WalletHub’s Island Approach to Credit Card Spending

Mar 26, 2011 | Odysseas Papadimitriou, WalletHub CEO

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The WalletHub Island Approach is a theory for credit card use which suggests that consumers should use different credit cards to meet each one of their specific financial needs. This approach is built upon the idea of compartmentalization and suggests that by secluding different expenses and types of payments, almost as if they are on their own islands, consumers can address them in the most cost-effective, strategic manner possible. As a result, they will be able to minimize interest costs, gain increased financial control, build discipline and maximize their credit card rewards.

The WalletHub Island Approach applies to every type of consumer, but its logic and value can be seen most clearly by separating people into two broad groups: those with revolving credit card debt and those who pay all their credit card bills in full every month.

Revolving Monthly Balance

The obvious goal of both consumers and small business owners who are in debt is to get out of it as quickly as possible. In order to accomplish this, they must do three things: minimize the portion of their payments consumed by finance charges, ensure fiscal predictability, and develop the discipline required to spend within their means. These goals are rarely, if ever, met by a single credit card.

Lower Interest Rates

The WalletHub Island Approach minimizes interest costs in three distinct ways. First, it helps lower your overall average monthly balance—the amount your APR is applied to. Imagine for a moment that you have $3,000 worth of credit card debt because you recently furnished your apartment, you charge roughly $500/mo. on everyday expenses, and you allot $600/mo. for credit card payments. If you use a single credit card to both carry your balance and make everyday purchases, your average monthly balance will be your outstanding credit card debt plus your monthly expenses. Therefore, the first month, roughly $3,500 will accrue interest; the second month, about $3,400; the third, $3,300; and so on.

If, however, you carry your debt on one credit card and use the other for everyday expenses that you will pay for in full, your interest costs will be far less substantial. Since you never revolve a balance on the card designated for everyday spending, the $500 you charge on this card will never accrue interest, and only the $3,000 balance—which will be paid down at a rate of $100/mo.—will incur interest. The first month, $3,000 will accrue interest; the second month, $2,900; the third, $2,800; and so on. In this example, using more than one credit card will result in 15% less debt accruing interest. While the exact percentage depends on how much you spend overall, this method will surely lead to savings.

Secondly, if you have different credit cards for different purposes (i.e. balance transfers, purchases that will not be paid for in full, etc.) you can focus on getting the lowest rates for each. In terms of the above example, it would be advantageous to be able to transfer the $3,000 balance from your furniture purchases to a low interest balance transfer credit card and also open a cash back credit card that provides rebates on everyday expenses, such as gas and groceries. No matter your particular needs, the WalletHub Island Approach fosters the ability to assemble the best possible customized combination of credit card attributes, which will provide far more benefit than any all-purpose credit card could.

Finally, the island approach prevents you from having multiple balances with different interest rates on the same card as would be the case if you transferred a balance onto the card you use for everyday purchases. When you have multiple balances on a single credit card, only payments above the minimum will be applied to the balance with the highest interest rate, meaning that it will take longer to pay down your most costly debt. If, however, each of your credit cards serves a specific purpose, not only can you open cards with the lowest rates, you can also disperse payments however you want.

Predictability

Unbeknownst to many small business owners, credit card companies can raise interest rates for business credit cards at will. Therefore, any balance held on a business credit card can become suddenly more costly simply because a credit card company executive decides that jacking up interest rates is the best way to get his bonus. However, the CARD Act instituted rules prohibiting credit card companies from raising interest rates on pre-existing balances held on personal (general-use) credit cards until account holders become at least 60 days delinquent.

This presents a dilemma for small business owners using one credit card: sacrifice the debt predictability garnered from a personal credit card or forgo the unique business tools provided by a business credit card.

The WalletHub Island Approach makes such a tough decision unnecessary. Simply segment business spending by using a personal credit card for significant purchases that will lead to a monthly balance and a business credit card for the purchases that will be paid for in full by the end of the month. In addition and contrary to popular belief, business credit cards with no personal guarantee do not exist. As a result, there is no liability difference between personal and business credit cards.

Financial Discipline

WalletHub’s Island Approach promotes organization and financial clarity as well. Segmenting your balances and spending needs will help you better judge the overall state of your finances, thereby allowing you to strategically and effectively allot payments, adjust spending and increase savings.

More specifically, this approach promotes discipline since it calls for you to pay for your everyday purchases in full every month. By isolating your everyday spending, you’ll be able to clearly gauge whether or not your monthly spending exceeds your ability to pay and, if necessary, make the targeted lifestyle changes required to achieve a healthy financial balance.

Once you have altered your spending habits to the point that you habitually pay for your everyday expenses in full, spending beyond your means will provide more of a wakeup call should it ever occur. Since you’re used to never paying finance charges on your everyday-use credit card, their sudden appearance will provide shock-value and will obviously signal risky spending. If you only have one credit card, excessive spending might not get noticed because it will only add to the debt you already have. However, if you spend more than you can afford on a credit card whose bill you always pay in full, your fiscal irresponsibility will be starkly apparent.

Rewards Segmentation

Consumers who don’t carry credit card debt can make use of WalletHub’s Island Approach in a much different way than those who do. Since they have no debt, lowering interest and instilling discipline are not relevant. Rewards, however, are. Much as consumers with debt put their different balances and expenses on islands, those without it can segment different types of transactions.

In order to apply the Island Approach to rewards credit cards, you must first find the best cash back credit card possible. This will serve as your baseline. Next, evaluate your lifestyle, determine your top spending categories (e.g. gas, groceries, travel, etc.) and find the credit cards that provide the most lucrative rewards for these types of purchases. If these cards provide much better rewards than the cash back card, which likely offers 1% on all purchases, open them. If they don’t or you have no specific spending categories that stand out, simply use the cash back option for all of your purchases.

Should you use multiple rewards credit cards, remember to limit use of each card (both for earning and redemption purposes) only to its specific rewards genre. Lack of proper segmentation will limit rewards potential.

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